Too many investors wait until late in the year to maximize after-tax investment returns. That costs them a lot of money.
Later this year, most financial publications and websites will run articles on “year end tax planning for investors.” The problem is you should be mulling these strategies all year. Every time you consider a change in your portfolio or see a major move (up or down) in one of your investments, it’s time to consider tax strategies.
Of course, I’m talking about assets held in taxable accounts, not those held in traditional IRAs, 401(k)s, and other tax-advantaged accounts.
First, learn what tax pros call the netting process. Few investors know these rules, and even fewer carefully consider them. But they can have significant consequences, especially when you own mutual funds.
You know that investments held for one year or less are short-term assets that generate short-term capital gains and losses. Investments held for longer than one year are long-term assets. Long-term capital gains are tax-advantaged, because they face a maximum tax rate of 20%. Investors below the top tax brackets pay a lower rate, and the lowest brackets pay 0% on their long-term capital gains.
Capital gains and losses are reported on Schedule D of your individual income tax return, Form 1040. That’s where the netting rules come into play.
On Schedule D, first you list your shortterm gains and losses together and determine the net short-term gain or loss. For example, if you have $2,000 of short-term gains and $1,000 of short-term losses, you have a net $1,000 short-term gain.
Then, you list your long-term gains and losses and find your net long-term gain or loss for the year.
There are three possible outcomes from the netting process.
You could have both net short-term gains and long-term gains. The net short-term gains will be taxed as ordinary income, and the net long-term gains will be taxed at your long-term gain rate.
You could have both net short-term losses and net long-term losses. In that case, you can deduct up to $3,000 of the losses against other income and carry forward the excess loss to the next year.
You could have a net gain in one category and a net loss in the other. They’ll be netted against each other. For example, Max Profits has a net short-term capital loss of $5,000 and a net long-term gain of $20,000. That gives him a net long-term capital gain of $15,000 taxed at his long-term capital gain rate.
The netting process usually is done seamlessly by tax preparation software or your tax preparer, but knowing the process helps you plan.
Now, on to some strategies to consider all year
Recognize losses. Most investors are hesitant to take or recognize their losses. They want to wait until the asset at least returns to their purchase price. But that’s a bad use of capital. It’s better to do what many tax pros call “harvesting losses.”
First, your capital is freed to invest in something that has better prospects. It is better to put that capital in something that generates at least a modest gain or income than to leave it in a stagnant investment waiting for the turnaround.
Second, once the investment is sold, you enter the loss on your Schedule D. There it shelters capital gains (both short-term and long-term) and perhaps other income.
Third, once you recognize a loss you are freer to take some gains. Let’s say you bought Price Latin America early this year or late last year. You have a double-digit-percentage gain. You’d like to book some of that gain, but if you sell shares now it will be a short-term capital gain. Since you recognized a tax loss on another investment, however, you can sell some shares of PRLAX and pocket the gain tax free.
Know the wash-sale rules. The tax code won’t let you deduct a loss if you immediately bought back the same investment. Instead, your loss is deferred until you sell the newly-purchased investment. These are the wash-sale rules. They apply if you bought a substantially identical investment within 30 days of when an investment was sold at a loss.
Sometimes investors are reluctant to recognize a loss, because they don’t want to be out of the market for more than 30 days.
You can avoid this dilemma by selling the investment and buying one that is similar but not “substantially identical.” For example, you can sell PRLAX and buy another Latin American stock fund or ETF. Or you can sell an S&P 500 Index fund and buy a Russell 3000 Index fund. For individual stocks, you can sell one stock and buy a competitor or an ETF for the industry
Avoid short-term gains. Ideally you hold stocks, mutual funds and other investments for more than one year so you pay the longterm capital gain rate instead of the ordinary income rate. Investments you are likely to hold for the short term should be owned through tax-deferred or tax-free accounts.
Plan when to take long-term gains. When you’ve held an investment for a while, it’s always tough to know when to sell. Though the long-term gains rate is lower than the ordinary tax rate, many people still balk at seeing part of their gains siphoned off by taxes. I’ve known people who held winning stocks for many years simply because they couldn’t bear to write checks for the taxes.
Consider the reasons you purchased the investment. When you buy, you should have an idea of when it will be time to sell. If you don’t have clear sell rules, ask yourself if you would sell this investment if it weren’t for the taxes. Another good question: Would you buy it today?
You also should consider the risk of continuing to hold. Suppose Max Profits purchased $10,000 of a mutual fund two years ago that now is worth $20,000. He’s in the 20% long-term capital gains bracket, so a sale incurs $2,000 in taxes or 10% of the position’s value. Max has to ask himself what the probability is the fund will decline more than 10% and not recover for a while. If the probability is high, then the certainty of paying 10% in taxes to exit the position is better than taking the risk the fund will decline more than 10%.
A third consideration is the opportunity cost. Sometimes an investment appreciates a lot and then lags the market. Microsoft’s stock, for example, was essentially stagnant from 2002 through early 2013. After an investment has appreciated, ask yourself if you could have more money two years from now by selling the investment, paying the taxes and investing the after-tax proceeds in something else.
You also don’t have to sell the entire position. You could sell a portion each year so the sales won’t increase your adjusted gross income and trigger the Stealth Taxes. Or sell enough to cover your initial investment, so that now you’re playing with “the house’s money.”
Is your tax bracket changing? Small business owners often see their incomes vary significantly from year to year. Or your income might drop a lot because it’s the first year of retirement or you left a job without immediately finding a new one.
When your income drops, consider recognizing some gains you otherwise wouldn’t, because they will be taxed at a lower rate. There are no wash-sale rules for gains, so you can buy back the investment immediately if you still like its long-term prospects.
Charitable gifts. When you’re charitably inclined, donating investments often can be the best strategy.
When you give appreciated long-term investments to a charity, you don’t pay taxes on the appreciation that occurred while you held it. You deduct as a charitable contribution the current fair market value. The charity can sell the investment tax free. So, instead of selling the investment, paying the taxes and writing checks to charity, consider donating some mutual fund shares or other appreciated investments. You are likely to be better off, and the charity has the same amount of money. Talk with a tax advisor to iron out the details.
Family transfers. You might want to help family members who are in lower tax brackets. Instead of selling your investments and giving them cash, give the assets. Let the family members sell and pay taxes at their lower rates. The family has more after-tax wealth that way.
Anticipate mutual fund distributions. Mutual funds generally aren’t taxed, because they are required to distribute all or most of their gains and income for the year to shareholders. When the distribution is made, the net asset value of the fund declines by the same amount. You have to include the distribution in gross income, though you sold no shares. In general, but not in all instances, the distribution has the same character for you that it had for the fund. In other words, a long-term capital gain by the fund is distributed as a long-term gain to you. But there are exceptions we’ll go over.
There are some tricks to mutual fund taxation.
Most funds, especially stock funds, wait until late in the year to make distributions. You often want to avoid buying shares in a taxable account in November or December, because you’ll receive part of your money back as a distribution and will have to include it in gross income, though it’s really a return of your investment. You can sell the fund right away and have a capital loss to deduct, but that’s inconvenient. Plus, in a quirk in the mutual fund tax rules, if the fund made a long-term gain distribution and you sell immediately afterward and after holding the shares for less than one year, you have to treat the loss as a long-term loss to the extent of the long-term gain distribution.
Most funds now estimate their yearend distributions in the fall and post the estimates on their web sites. They also give estimates over the telephone.
Losses by mutual funds aren’t distributed. These stay on a fund’s books and can be used to offset its future gains. If you like a fund that does a lot of trading and normally distributes significant short-term gains, it can be a good idea to buy after the fund has a bad year or two. Some of the future gains will be sheltered by the recent losses.
When a mutual fund earns short-term gains, they aren’t distributed to you as short-term gains. They are listed as ordinary income or ordinary dividends on your Form 1099-B. So, you don’t put the short-term gain distributions on Schedule D where losses can shelter them.
I think it’s generally not a good idea in taxable accounts to automatically reinvest dividends, especially if the fund makes distributions more frequently than annually. That’s because when you want to sell fund shares, especially less than 100% of a position, you have to figure out the basis of your shares. That can be tiresome when distributions were reinvested over time. You can use the average basis computed by the broker or mutual fund, but that takes away some planning options.